Investors Hammer Stocks of China's Big Four Banks

The world’s most-profitable banks have never been so unloved by stock investors.

China’s four-biggest lenders, which reported $126 billion of earnings in the 12 months through September, sank to the lowest valuations on record in Hong Kong trading Thursday. The MSCI China Financials Index dropped to an almost decade low versus the global industry benchmark while the market value of Industrial & Commercial Bank of China Ltd., the nation’s largest lender, fell below net assets for the first time on Wednesday.

The state-controlled banks known as China’s Big Four are getting squeezed by slower economic growth and rising bad debts just as policy makers open up the nation’s financial system to non-government competitors. Their shares have lost $70 billion of value this year, equivalent to the size of New Zealand’s entire stock market, even as U.S. and European peers rally. Wells Fargo & Co. and JPMorgan Chase & Co. have knocked ICBC from its ranking as the world’s biggest bank by market value.

“The market is concerned about future profitability” in China, Diana Choyleva, the head of macroeconomic research at Lombard Street Research, said by phone from London on Tuesday. “I would not be investing Chinese bank shares just yet. They have further to go.”

ICBC, China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. were stock-market darlings as recently as 2011, when the world’s second-largest economy was growing at close to 10 percent and banks reaped profits from a $3 trillion lending spree during the previous two years. Now investors are concerned that those loans will turn sour at an increasing rate as growth slows toward 7.5 percent, the weakest annual pace since 1990.

Free Market

At the same time, the ruling Communist Party’s plan to increase the role of markets in China poses a threat to state-owned banks that have benefited from tightly regulated interest rates. Central bank Governor Zhou Xiaochuan said on Tuesday that the government will free up deposit rates within two years, while the China Banking Regulatory Commission said the same day it has approved a trial program to establish five privately-owned banks.

“The more the government moves to freeing the market, the more they have to compete on more level terms,” Michael Aronstein, whose $21 billion MainStay Marketfield Fund has outperformed 96 percent of peers tracked by Bloomberg during the past three years, said in a phone interview from New York. “They are not prepared to do that. It’s like releasing your house cat into the jungle.”

Valuations Slump

Calls to spokesmen at ICBC, China Construction Bank and AgBank weren’t returned. A Bank of China official said she couldn’t immediately comment.

The Big Four banks, all based in Beijing, have tumbled an average 15 percent in Hong Kong this year, led by an 18 percent retreat in AgBank. The shares are valued at a mean 0.94 times net assets, or book value, the lowest level since AgBank’s initial public offering in 2010 and down from a level of 2 in March 2011, data compiled by Bloomberg show. JPMorgan, the biggest U.S. bank by total assets, has a price-to-book ratio of 1.08, while BNP Paribas, the largest French lender, fetches a multiple of 0.87.

The MSCI China Financials Index, which includes banks along with developers and securities firms, trades at about the same level as its net assets, a 19 percent discount versus the MSCI All-Country World Financials Index. The Hang Seng China Enterprises Index, a benchmark for mainland companies listed in Hong Kong, has dropped 14 percent this year and is valued at 1.1 times book.

‘Worst Case’

Some analysts say the bank stock sell-off has gone too far. ICBC is poised to rebound and will surge 38 percent over the next 12 months, according to the average of 24 analyst forecasts. China Construction Bank has a return potential of 42 percent while AgBank may increase 28 percent, according to estimates tracked by Bloomberg.

“Even in the worst case scenario of a sharp increase in nonperforming loans, the impact for the banks’ net profit will not be very significant,” said Steven Chan, an analyst in Hong Kong at Maybank Kim Eng Securities Pte, which has an overweight rating on Chinese banks.

Lenders rallied in early Hong Kong trading Thursday on media reports that regulators will allow them to sell preferred shares for the first time, giving banks a new way to meet long- term fundraising requirements. The shares then erased most of the gains after data showing China’s industrial-output, investment and retail-sales growth cooled more than economists estimated in January and February.

Weakening Expansion

The figures were the latest signs of a weakening expansion in the $9 trillion economy. Previously released data for February showed exports unexpectedly plunged the most since the global financial crisis, producer-price deflation deepened and credit growth trailed estimates.

The slowdown is making it harder for Chinese borrowers to repay their debts. Nonperforming loans increased by 28.5 billion yuan ($4.7 billion) in the last quarter of 2013 to 592.1 billion yuan, according to the banking regulator. While that’s still just 1 percent of total lending, it’s the highest amount since September 2008.

Some lenders are increasingly financing insolvent companies to help them pay off maturing debt in a bid to avoid outright defaults, according to Mike Monnelly, a money manager at Arhammar Global Capital Management LLP in London. The practice, known as evergreening, reduces banks’ ability to lend to profitable businesses, he said.

First Default

“The capital consumed by evergreening is capital that could otherwise be used productively,” said Monnelly, a former analyst at hedge fund Kynikos Associates Ltd., which rose to fame shorting Enron Corp. before the energy company went bankrupt.

China averted its first trust default in at least a decade in January as investors in a troubled 3 billion-yuan high-yield product issued by China Credit Trust Co., and distributed by ICBC, were bailed out days before it matured.

Creditors of Shanghai Chaori Solar Energy Science & Technology Co. weren’t so lucky. The company became China’s first onshore corporate bond default after failing to pay a coupon due on March 7.

Total debt of publicly traded nonfinancial companies in China and Hong Kong has surged to $1.98 trillion from $607 billion at the end of 2007, while the number of companies with debt twice their equity has increased 57 percent.

‘Even Cheaper’

“The Chinese banking sector has to initially address the perceived risk in its system, and by doing so, lift some of the uncertainty revolving around asset quality,” Ismael Pili, a Hong Kong-based analyst at Macquarie Group Ltd., wrote in an e- mail. Pili recommends underweighting Chinese banks, while favoring lenders in the Philippines, Japan, Singapore and Indonesia.

After years of earning a government-controlled spread between what they pay for deposits and charge for loans, China’s big banks now face increased competition for both.

PBOC’s Zhou said at a briefing in Beijing on Tuesday that deposit rates will be liberalized in one to two years, while reiterating that interest rates will initially rise as controls are removed.

The banking regulator will allow privately owned banks to be set up in the cities of Shanghai and Tianjin, along with Guangdong and Zhejiang provinces. Alibaba Group Holding Ltd., the Internet company that sells China’s biggest money-market fund online, said it plans to apply jointly for a license with China Wanxiang Holding Co.

Investors in Chinese banks are concerned “the ongoing interest-rate liberalization will squeeze their profits,” Wang Weijun, a Shanghai-based strategist at Zheshang Securities, said by phone. “Over the short or medium-term horizon, pessimism over the industry is still there and share prices could become even cheaper.”